Financial leverage: The degree to which an investor or business is utilizing borrowed money.
The last 25 years have been all about leveraging and leveraging is all about probabilities with one exception. That exception happens with Our Heavenly Father tells you to borrow. Borrowing is not a sin. There are specific Scriptures relating to usury. The borrower is subject to the lender and agrees to submit to specific terms and conditions.
When times are good we all become optimistic about the future and its opportunities. Along with opportunities comes expected increases in income and cash flow. There is no end in sight. The assumption is that asset values will always rise and if you buy a house, it will increase in value. For many that assumption held true during their adult life. Those that lived through the Great Depression had a reality check. The Roaring 20’s had seen dramatic increases in asset valuations. Life was good. After the Stock Market Crash of ’29, the market did have days of recovery. See the following graph:
This precipitous drop did not wipe out all stock share values. It wiped out capital of people who had leveraged up their investments.
Excerpt of the Crash of ’29 (from http://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929):
…After an amazing five-year run when the world saw the Dow Jones Industrial Average (DJIA) increase in value fivefold, prices peaked at 381.17 on September 3, 1929. The market then fell sharply for a month, losing 17% of its value on the initial leg down. Prices then recovered more than half of the losses over the next week, only to turn back down immediately afterwards. The decline then accelerated into the so-called "Black Thursday", October 24, 1929. A record number of 12.9 million shares were traded on that day.
The crash followed a speculative boom that had taken hold in the late 1920s, which had led hundreds of thousands of Americans to invest heavily in the stock market, a significant number even borrowing money to buy more stock. By August 1929, brokers were routinely lending small investors more than 2/3 of the face value of the stocks they were buying. Over $8.5 billion was out on loan,[26] more than the entire amount of currency circulating in the U.S. The rising share prices encouraged more people to invest; people hoped the share prices would rise further. Speculation thus fueled further rises and created an economic bubble…
Does any of this story sound familiar? Hedge funds leveraged their capital 30 to 1 and higher speculating that prices would climb even further. They used complex algorithms (formulas) to determine which stock or stocks to buy, how much, and at what price. Their formulas were correct 90-95% of the time. We are now dealing with the 5%.
What is the impact of "de-leveraging" on good stocks? The stock prices will be pushed down during this de-leveraging process. Why? In order to raise cash to cover the borrowing against bad positions, the investor must sell anything and everything, even the good, sound stocks. Thus the selling pressure outweighs the buying pressure and the price declines.
The people that made money during the Great Depression were those who had cash and could wait for the market to bottom out and then pick up quality investments for pennies on the dollars. Those who went into the Great Depression highly leveraged lost it all. In despair, some jumped out of windows to their death.